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The Secret Ingredient to Find the Next Chipotle or Buffalo Wild Wings

Investors often look for the next Chipotle Mexican Grill (NYSE: CMG) and Buffalo Wild Wings (NASDAQ: BWLD) in the restaurant field, and for good reason: both stocks have returned more than 1,000% over the past 10 years, compared to a measly 60% return from the S&P 500. Noodles & Co. (NASDAQ: NDLS) , Chuy's Holdings (NASDAQ: CHUY) , and Potbelly (NASDAQ: PBPB) have recently arrived on the scene and are being compared to Chipotle and Buffalo Wild Wings. While these restaurants have promising concepts and long-term potential, they are missing a key ingredient that has led to the phenomenal success of Chipotle and Buffalo Wild Wings.

Free cash flow Why is free cash flow important, especially for restaurants? Free cash flow -- which is operating cash flow minus capital expenditures -- measures how much cash remains with a business after investing in property, equipment, and other items necessary for the expansion of that business.

Operating cash flow -- the cash flow produced by a business -- can either fully cover capital expenditures (expansion costs) or a business will be required to borrow money (i.e. go into debt) or issue stock (diluting shares outstanding). Put in other words: if a business has negative free cash flow, it is a signal that the business itself is not producing sufficient cash flow to finance expansion.

This is a critical point that's easy to overlook. Looking back at Buffalo Wild Wings and Chipotle Mexican Grill, we can see the importance of finding young restaurants with promising concepts that are capable of expanding without going into debt or issuing thousands of new shares of stock.

Buffalo Wild Wings went public in 2003 with a market capitalization of approximately $216 million. At that time, the company operated 245 restaurants in 29 states. In 2003, the company produced $16.07 million in operating cash flow, while capital expenditures totaled $10.74 million; this means the company's free cash flow for the year came out to $5.33 million. Buffalo Wild Wings continues to produce positive free cash flow today, and is aiming to open its 1,000th restaurant this year and open 1,700 restaurants by 2023.

Chipotle went public in 2006 with a market capitalization of roughly $1.36 billion. At that point, Chipotle operated 489 restaurants (including eight franchised locations) in 21 states. In 2006, the company produced $103.6 million in operating cash flow, with capital expenditures coming in at $97.31 million. Chipotle produced $6.20 million of free cash flow in its first year of being a public company. This cash flow production has allowed Chipotle to build up $532.17 million in cash on its balance sheet with no debt, a major financial cushion as the company continues to build upon its base of over 1,500 restaurants and fledgling ShopHouse and Pizzeria Locale concepts.

How Noodles, Chuy's, and Potbelly stack up Noodles & Co. -- which is stacked with former executives from Chipotle -- oversees a total of 380 fast-casual restaurants (both company-owned and franchised) in 29 states and the District of Columbia. In 2012, Noodles produced $32.07 million in operating cash flow, but capital expenditures stacked up to $47.38 million -- leading to negative free cash flow of $15.31 million. In the first three-quarters of 2013, the company produced negative $7.33 million in cash flow.

Not only that, but in its third-quarter conference call, CEO Kevin Reddy said this is not expected to change anytime soon. "We do anticipate the long-term debt we'll increase a bit over the next few quarters as our operating cash flow is modestly lower than that capital we deploy investing in the restaurants."

Yikes! Noodles is, for now, expanding beyond its means. This places significant pressure on new locations to produce positive free cash flow in order for the company to pay off a growing chunk of debt. This is a key thing to watch for with Noodles, whose management team envisions 2,500 Noodles locations in the U.S.

Chuy's -- a relatively small Tex-Mex chain with 47 restaurants in 14 states -- has a concept which is quickly growing in popularity. In 2012, the company produced $24.52 million in operating cash flow with $27.25 million in capital expenditures, making for free cash flow of negative $2.73 million. In the first three-quarters of 2013, the company's free cash flow stands at negative $2.7 million. Chuy's plans on opening 10 or 11 new restaurants in 2014, but it's unlikely for this expansion to occur without it adding more debt or issuing new shares of stock.

Potbelly operates 288 shops in 18 states and the District of Columbia, as well as 19 franchised locations both in the states and the Middle East. In 2012, Potbelly's operating cash flow nearly outgrew capital expenditures, still the company produced just under $1 million in negative free cash flow. In the first three-quarters of 2013, however, the company did produce positive $3.11 million in cash flow. Should it continue, this trend will serve Potbelly well as it plans to open 30 new sandwich shops each year.

Foolish bottom line We should remember that Chipotle and Buffalo Wild Wings didn't always produce positive free cash flow. But, upon entering the public stage, both companies fueled their successful national expansions through funds generated by the actual business (rather than debt or stock issuance). Put in other words: Chipotle and Buffalo Wild Wings have funded the development and opening of new locations through the cash flow generated by existing locations.

It remains to be seen whether Noodles, Chuy's, and Potbelly can sustainably grow and open new locations without being forced to go into debt or issue more shares of stock. Noodles, despite its managerial roots with Chipotle, is unlikely to be free cash flow positive in 2014. Chuy's is teetering on the edge of producing positive free cash flow, while last year's numbers seem to show Potbelly is capable of funding expansion through its operating cash flow.

Noodles, Chuy's, and Potbelly all have ambitious expansion plans. If you're looking for comparable businesses (and investment returns) to Chipotle and Buffalo Wild Wings, focus on finding a business capable of financing growth through existing cash flow production. Without this component, there's no telling whether you have actually found a restaurant gem or a concept incapable of expanding without debt and equity financing.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

David, first off I loved the article. Your point is spot on with the cash flow. My question is why you said "adding" to debt with Chuy's? It's paid its debt down over the last several quarters. Noodles is down to a measly $1 million and Potbelly I believe is paid off with the IPO. None of these companies are even close to letting debt be a problem.

But again, your point is spot on, especially when it comes to the secondary offerings. Noodles had one, I think Chuy's did, and I wouldn't be surprised if Potbelly did. Cash flow is so huge for these expanding chains.

"Chipotle went public in 2006 with a market capitalization of roughly $1.36 million. At that point, Chipotle operated 489 restaurants (including eight franchised locations) in 21 states. In 2006, the company produced $103.6 million in operating cash flow"

For now, each of the companies have been able to pay down debt by issuing stock. This is a short-term fix to the "problem" until the businesses themselves can produce positive free cash flow. I'm more concerned with what this signifies (rather than the amount of debt): negative free cash flow is a signal that the business is not generating the necessary cash to finance expansion internally.

Right now, none of the three companies are swimming in debt, but they are yet to prove whether they can generate sufficient cash flow internally to finance very ambitious expansion plans. I plan on watching closely in the coming quarters/years.

thequast - One more point. The way the three businesses are currently operating (except, possibly, Potbelly) they will need to add debt to the balance sheet at some point. Stock offerings have, for now, helped them avoid growing debt (like you mentioned, they have actually paid down debt).

However, whether it is debt or equity financing, the point remains the same: the businesses are currently incapable of producing sufficient cash flow. Chuy's and Noodles are especially on a trajectory that will lead to the addition of more debt soon, unless more stock offerings are in store (which isn't much better).

Sending report...

David started investing in stocks when he was 12 years old and has been a Fool ever since. He is a graduate of Berea College and a member of the Motley Fool's Analyst Development Program, currently serving as an analyst in Rule Breakers and Supernova. Follow David on Twitter @David_Kretzmann.